All eyes on Saudi as oil balance risk looms

New York, January 18, 2014

Exceptional supply disruptions roiled the global oil markets in 2013, with Libya and Iran alone deducting 2.3 million b/d from balances last quarter. While progress to date is tentative at best, a simultaneous normalization in both Iranian and Libyan oil exports is a real risk for the global oil balance in 2014, said a report by Bank of America Merrill Lynch.

If some or all of their production was to return, this could create meaningful downside pressure on prices. In an extreme case, where non-Opec production strengthens and Libya and Iran partially or completely recover, the global oil supply-demand balance could see a swing of 1.5-3 million b/d, on our estimates, stated BofA Merrill Lynch in its global research, titled, "BofA Global Energy Weekly – All Eyes on Saudi."

Indeed, the start of a new year has brought some moderately positive news. Last weekend, the first step was made in the Iranian accord, as Iran and the Security Council + Germany set a date to begin implementing the Joint Plan of Action, signed in late November, on January 20.

From now until July 20, Iran agreed to freeze their most sensitive nuclear work in exchange for gradual and partial sanctions relief, including repatriation of assets and the lifting of sanctions on petrochemicals exports, gold trade and tanker insurance, said the BofA Merrill Lynch report.

Of course, we are still a long way from reaching a final agreement on the scope of Iran’s nuclear program and, thus, restrictions on Iran’s crude oil sales remain firmly in place, it stated.

In Libya, the recent start-up of the 340,000 b/d El Sharara field, where protests lasted for 90 days, brought output back up to 600,000 b/d. That is up from 250,000 b/d at the end of last year, but remains far below post-civil war highs of 1.4 million b/d.

Significant risks remain and protesters just threatened to shut the field again if their demands were not met by the government. Tensions remain high, as attempts by the Cyrenaica separatist movement in the east to sell regional crude oil have been met with threats of force by the central government. Moreover, it is not exactly clear whether the protest movement demands a higher share of oil revenues or effective control of some oil assets, the report added.

While entirely hypothetical at this stage, a partial or full return of production in both countries requires a synchronized response from other Opec members to cut back. Most of the heavy lifting in terms of absorbing the supply losses was done by Saudi Arabia, which saw a big step-level increase in production, stated BofA Merrill Lynch in the report.

Since mid-2011, production averaged 9.7 million b/d, compared to 8.8 million b/d from 2003 to 2010 (Chart 6). 2011 saw the strongest rate of output growth since 1991, of 1.2 million b/d, with 2012 adding further to supplies before moderating slightly in 2013, it pointed out.

Monthly output exceeded 10 million b/d on six separate occasions since November 2011. As worker strikes and civil unrest sent Libyan output plunging again in 2013, Saudi Arabia once again reacted quickly, it said.

"Will Saudi Arabia cut back if output returns in the disruption countries? Historical evidence suggests they will make room for a moderate rise in output in other Opec countries," said BofA Merrill Lynch.

In 2012, a recovery in Libyan output led Saudi Arabia to cut output down to as low as 9.2 million b/d in December from 10.1 in June. This was one of the four times since the 1990s that Saudi took out 1 million b/d of supply or more in less than 6 months.

However, the most Saudi Arabia ever cut back within a year is 1.5 million b/d, which pales in comparison to a theoretical full return of Libya and Iran of 2.4 million b/d. Other Opec members may not be of much help.

Meanwhile, it is unlikely that other Opec members would willingly cut back, as most of them are fighting output losses. Nigeria has long struggled to deal with oil infrastructure sabotage and theft, and disruptions picked up in 2013, leading to several force majeures and pipelines disruptions.

BofA Merrill Lynch pointed out that the monthly output surpassed the 2 million b/d mark only once last year. Production in Angola and Algeria also declined in 2013, with the latter seeing particularly heavy declines over the last few months, despite the start-up of the new El Merk field.

Even in Venezuela, production has been falling since August, as new heavy oil projects in the Orinoco Belt have failed to keep output steady.

According to BofA Merrill Lynch, Kuwait and the UAE were the only Opec-11 producers to increase production in 2013, but even their gains were muted (65 and 50 k b/d YoY, respectively).

Output in both countries has been rising steadily since 2009, given the focus on enhancing oil recovery rates at existing fields, said the report.

"We expect UAE production to find some support going forward, given the start-up of the Qusawirah field in late 2013. More importantly, production out of Iraq, currently not obliged by output quotas, is expected to increase this year, as major projects are ramping up. This makes Saudi’s burden of cutting back even more difficult," it added.

Indeed, most Opec producers have to focus on raising production in order to maximize revenues. Facing a myriad of problems, including limited access to foreign capital, government funding issues, collapsing currencies or unstable political systems, several Opec countries depend heavily on oil revenues.

Rising fiscal budgets in the wake of the Arab Spring have only exacerbated these challenges. With the exception of Gulf producers Kuwait, the UAE, Qatar and, of course, Saudi Arabia, most Opec-11 countries are now running fiscal deficits. Thus, we believe it will be difficult for Opec producers to cut output in response to receding supply disruptions, said the review.

That leaves the markets depending on Saudi Arabia to bear the responsibility of balancing global oil markets, it added.

BofA Merrill Lynch said Saudi had consistently run fiscal surpluses for the past decade, with the only exception being 2009.

"According to our economists, Saudi’s current budgetary breakeven oil price stands at 85/bbl. This assumes production of 9.5 million b/d, broadly flat to last year. Based on that, we estimate production could drop as low as 7.8 million b/d before expenditures overtake revenues at current Brent prices. This would be the lowest level of annual production since 2002," the report added.

The problem really starts at higher production cuts in response to a more substantial supply shock. For instance, a positive shock of 1.5 million b/d that is met by a Saudi cut of 1 million b/d would bring full-year Brent prices down to an average of $95/bbl (versus our forecast of $105/bbl), all else equal.

This could throw Saudi into a budgetary deficit, likely financed by the government stock of foreign assets. Additional non-Opec supply increases above demand growth or an even larger supply shock could further depress prices, widening Saudi’s budgetary deficit.

Despite weak output levels across much of Opec-11, spare capacity stands at very low levels. According to our estimates, total Opec-11 spare capacity stoodnat 4.5 million b/d last year, down from highs of 6 million b/d in 2010.

Effective spare capacity, excluding Nigeria, Libya and Iran, is down to 3.2 million b/d, more than 2 million b/d below 2010 levels. Most of the spare capacity is held by Saudi Arabia, where crude productive capacity dwarfs all other Opec-11 countries by a factor of at least 4. No other Opec producer has any material amount of spare capacity to speak of.

Saudi Arabia has been able to maintain spare capacity given the addition of new giant fields over the past few years. The country added the massive 1.9 million b/d Khurais field in 2009 and then the 900 thousand b/d Manifa field started to come online in 2013.

Although much of the growth helped offset declines at older, more mature, fields, these new projects have kept productive capacity mostly at or above 12 million b/d, in and of itself no easy feat. Productive capacity has also improved in fellow Gulf producers Kuwait and the UAE over the past few years, as well as in Angola, the report added.

BofA Merrill Lynch expects capacity growth within Opec-11 countries to remain muted. "Saudi Arabia will ramp up their giant Manifa field, but we do not see any other projects coming online until 2017. Growth in the UAE may stall with the recent expirationnof long-term concession contracts, while Kuwait faces a lack of new projects," said the report.

"The major source of growth will likely be Iraq, but output continues to be constrained by infrastructure limitations, deteriorating security on the Kirkuk-Ceyhan pipeline and growing tensions with the Kurdistan Regional Government. Yet limited spare capacity across Opec and a seasonal increase in Saudi domestic demand ahead should prevent Brent prices from falling sustainably below $90/bbl," it added.-TradeArabia News Service